1. Field of Invention
The present invention relates generally to asset classes performance calculation. More specifically, the present invention relates to systems and methods for measuring private equity (and generally private capital) investment performance, that would otherwise be measured in IRR terms.
2. Discussion of Related Art
Performance measurement is an important task for both investors and investment managers. Whichever asset class is considered, performance must be calculated in order to measure and compare the profitability of investments and to adopt proper risk management and asset allocation methodologies.
As private equity is increasingly becoming a typical investment allocation for institutional investors, banks, and high net worth individuals, its risk/reward characteristics need to be better understood and managed like for any other asset class. Unfortunately, applying standard performance evaluation techniques to private equity is a challenging task.
In fact, the lack of time series of market prices makes objectively difficult the use of standard risk management and asset allocation methodologies and the definition of the absolute and relative risk profiles for private equity.
Private equity investing, differently from all other asset classes, require the capital committed normally not being invested immediately at the subscription of the contract, generally a Limited Partnership Agreement (LPA); the committed capital is rather “called” to be invested by the general partner (GP or investment manager) discretionarily both in terms of timing and quantity, within the limits set in the LPA, over the certain terms of the contract. Therefore, private equity investments require and generate a stream of negative and positive cash flows spread over the term of a contract.
In this context, the main performance measures that have been used in practice in the art are the Internal Rate of Return (IRR) and variants thereof, and so called multiples on capital.
An example of such approach will be now illustrated with reference to FIGS. 1a and 1b, which illustrate representative pro-form a cash flow patterns of an hypothetical private equity fund, considered on a stand-alone basis.
In this simplified representation, an hypothetical investor (limited partner—LP) who commits 100 cash units to a fund that contractually is expected to have a 10 years term, over this term will see the cash called and returned by the investment manager (the GP) as described respectively by the contributions and distributions rows of the table depicted in FIG. 1a. The consequent investor's cash and total wealth positions are arithmetically derived in the table, under the assumption (as in the art) that the net asset value of the investments in place (NAV Invested Capital) is calculated as the net asset value of the future net cash flows, discounted at their pooled internal rate of return.
By investing (i.e. committing his total initial wealth of 100—the stand alone hypothesis) in the representative fund described by FIG. 1a, the hypothetical investor sees, over the 10 years term, his net wealth growing from 100 to 230 cash units. On a stand alone basis, he will calculate his net wealth to have increased in the 10-year period by a compound annual growth rate (CAGR) of 8.7%. The GP will instead (customarily) summarize the results of its investment activity by reporting the standard measures of internal rate of return (IRR) at 44% and multiple (Total Value versus Paid In—TVPI) of 2.3× on the invested capital.
FIG. 1b graphically depicts the cash flow patterns of the hypothetical fund being considered in FIG. 1a. 
The discrepancy between the IRR of the investment and the CAGR of the wealth is conceptually reconciled by analyzing the net cash utilization pattern of the private equity mechanics For the hypothetical fund considered, FIG. 1b shows that the maximum level of net cash drawn from the investor's commitment is 40 units (or 40% of the committed capital) reached at year 3. This means that, on average over the term of the contract, always more of 60% of the initial commitment is left to the investor. It also means that, on average, the investment manager has used less than 40% of the initially committed capital but overall has increased it by a factor of 325%.
The example shows the potential of private equity as a capital-efficient investment methodology, with capital efficiency effectively captured by the IRR measure. This is particularly true in cases, such as the one represented, when the private equity investments produce good results. Nevertheless, even in this simple case, the IRR measure fails to indicate how good these results are.
However, in general terms, neither the IRR nor the multiples are appropriate measures for the purposes of providing meaningful, and comparable, performance data for private equity. In fact such measures are prone to misleading indications, as will be shown below with another example, and with reference to FIG. 2.
FIG. 2 shows three different simplified investment opportunities, portfolio A, portfolio B and portfolio C, with identical cash flows but different timing. The performance of the three portfolios is identical both in terms of IRR (25%) and TVPI (1.5×).
Intuitively instead, the three initiatives may not be identically attractive as the performance indicators (identical IRR and TVPI value) could imply. Assuming identical commitment dates and amounts for the three opportunities, the initiative represented by Portfolio A provides a much faster turnover of the capital, invested at year 1 and fully divested at year 3. In other words Portfolio A appears to have a lower opportunity cost.
More misleading conclusions could be drawn without the information regarding the level of drawn capital versus the amount originally committed. In fact, while the limited use of capital increases the IRR, large amounts of committed capital left undrawn on the balance sheet of investors dilute the actual growth of their total wealth.
The several shortcomings of IRR and multiples with respect to calculation, to prioritization of investment projects and to comparison against the average return of to other asset classes are well known in the art.
In particular, it is known that IRR should not be compared to the average rate of return of stock market indices over the same period, not only due to the fact that IRRs and time-series averages of market returns are different in nature, but also because the underlying amounts invested in private equity at any point in time over the comparison period should be different from those of the equity market index.
Moreover, multiples, such as the Distributed over Invested Capital (DIC) or the Total Value over Paid In capital (TVPI), fail to take into account the time value of money and therefore their significance is limited in a context of comparison and prioritization of investment projects.
Alternative methodologies, such as the Public Market Equivalent (PME) and the Modified IRR (MIRR), have been proposed to overcome the above mentioned limitations; however, these methodologies in substance replace the IRR as reinvestment rate with a determined hurdle rate or a benchmark's rate of return, improving comparability but adding elements of subjectivity.
Summarizing, traditional methodologies for measuring private equity performance known in the state of art fail to provide performance indicators which are objective, meaningful, not misleading and comparable with the other asset classes.
In particular such methodologies do not take into account concepts such as financial duration and discounting to deal with the peculiarities of the capital call based investment mechanics, for which private equity is either cash at work or waiting to be deployed. When used, the concept of duration is calculated adopting subjective discount rates, such as the IRR, therefore hindering its effectiveness.
This leads to a “valuation isolation” anomaly, that causes private equity to be incomparable with all other asset classes; as a result, private equity is put at a disadvantage, in terms of general understanding and risk-return appreciation, versus most of the other asset classes.